May 26, 2013

MOSES HARRIS/DETROIT FREE PRESS

Written by

Detroit Free Press Business Writer

Once financially ailing, the revived Detroit Medical Center is out of the ICU and experiencing a midlife growth spurt courtesy of its for-profit owner.

DMC CEO Joe Mullany and other hospital leaders say publicly they’re thrilled with Nashville-based Vanguard Health Systems, which purchased the formerly nonprofit eight-hospital system in 2011 and has plowed about $280 million so far into new construction. It has promised to spend a total of $850 million on improvements by 2016.

But nearly 2½ years since the purchase, Vanguard is showing some signs of financial strain from its Detroit promises. Wall Street analysts note Vanguard’s high debt burden, with at least one analyst raising questions about the company’s long-term ability to fulfill its commitments to the DMC.

For now, Vanguard’s pledge is only slightly behind schedule, and DMC officials say their recent decision to lay off 300 employees was a response to Medicare spending cuts and a “proactive step” to streamline operations amid the changing health care business environment

“Health care organizations who are looking to ensure their long-term viability are looking for ways and means to be more efficient and cost competitive,” said Andrea Taylor, a DMC spokeswoman.

Last week’s unraveling of the planned mega-merger of Henry Ford and Beaumont health systems could help Vanguard’s long-term position in the metro Detroit health care market.

“A combined Henry Ford-Beaumont would be a very formidable competitor for them,” said Lance Gable, associate professor of law at Wayne State University. “I would suspect that they’re happy about what’s happened.”

Most financial analysts are not worried about Vanguard, at least in the short term. Sheryl Skolnick, a managing director at CRT Capital Group, said it makes sense for Vanguard to have high debt because interest rates are so low. “The publicly traded hospital model has always been a buy-it, fix-it, grow-it and do-it-again model,” she said. “They are knee deep (in debt) — not chest-deep yet — but knee deep into the fixing part of the strategy, and that requires significant capital investment, which they knew going in.”

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Many health care experts expect urban-market hospital systems like the DMC to benefit, in general, from the full rollout Jan. 1 of the Affordable Care Act, as more uninsured patients will gain coverage. And if the Michigan Legislature approves the Medicaid expansion in the health care law, an additional 500,000 low-income state residents will gain Medicaid eligibility and no longer be uninsured.

Vanguard Vice Chairman Keith Pitts said there is no reason for concern about Vanguard’s finances.

“We always meet our commitments,” he said in an interview.

In mid-April, DMC announced layoffs of 300 employees because of 2% Medicare cuts from the federal sequester. At the time, the DMC was the only major metro Detroit medical system to announce layoffs as a response to the sequester.

The DMC system remains a top employer in Detroit, with more than 12,600 full-time equivalent positions. It’s the fourth-largest system in the three-county metro Detroit area based on net patient revenue. No. 1 is Henry Ford Health System, No. 2 is Beaumont Health System and the third largest is St. John Providence Health System, according to the 2012 Michigan Health Market Review by consultant Allan Baumgarten.

As part of the 2011 acquisition deal, which ended DMC’s traditional nonprofit model, Vanguard agreed to the $850 million in capital expenditures and promised to keep all the hospitals operating for at least a decade. It also pledged to continue DMC’s legacy as one of Detroit’s few remaining “safety net” care providers for the poor and uninsured.

Mostly compliant

In its annual report last month, the local “Legacy DMC” committee tasked with monitoring Vanguard’s compliance with the DMC deal noted that Vanguard had fallen about three months behind schedule on its capital spending, and that the completion date for the most-expensive project — a $163-million tower for the Children’s Hospital of Michigan — has been delayed two years to 2017 to allow time for modernizing the plans.

The 20-member committee said it was concerned that Vanguard plans to violate what some consider a firm requirement that $350 million of the $850 million go to renovating and upgrading DMC’s aging hospitals — not for building any new clinics. The exact phrase in the contract refers to “routine capital expenditures in respect of the hospital businesses.”

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But in Vanguard’s opinion, the contract language allows the money to be spent on a new suburban outpatient clinic that was once proposed for $50 million in Royal Oak and is currently being relocated.

But the “Legacy DMC” group, in its report, does not agree the clinic is an allowable expense for that money, which is badly needed for the upkeep and upgrading of existing buildings.

The report concluded, however, that for the time being, Vanguard was mostly in compliance with the deal terms, but that “unforeseen economic issues could affect Vanguard’s capacity to fund the substantial remaining investment.”

“The combination of the slow spending patterns and the delay of the most significant investment raises the risk that this commitment will not be met within the (deal’s) time requirement,” the report stated.

In Free Press interviews, Pitts said his company intends to spend the full $850 million, if not with a few delays.

Vanguard, which owns 28 hospitals in five states — Michigan, Illinois, Texas, Arizona and Massachusetts — and has a market capitalization of about $1 billion, reported poor revenue earnings for its last completed quarter ending March 31. A decline in patient discharges and a rise in uncompensated care costs contributed to the quarter’s $84-million decrease in year-over-year revenue and $21-million decline in net earnings.

During its earnings conference call, Vanguard executives said the firm would trim its capital budget by about $100 million for the rest of its fiscal year. It will do that by delaying a project in Texas and adjusting the bill payment schedule for the DMC upgrades.

Facilities lacking

DMC began the year under new CEO Joe Mullany, who formerly headed Vanguard’s Massachusetts operations before starting early last year under Mike Duggan as the DMC’s No. 2 executive.

Duggan stepped down as CEO at the end of 2012 to launch his campaign for mayor of Detroit.

A former Wayne County prosecutor, Duggan took the job in 2004 to run the then-publicly owned hospital system. He’s widely credited with stabilizing DMC’s finances following a long-brewing crisis that required a $50-million bailout in 2003 from state, county and city governments.

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Although DMC’s financial health improved, by 2008 it still couldn’t generate the cash or obtain the bank financing for the large-scale building and equipment upgrades necessary to stay competitive with other hospital systems, according to a report by then-state Attorney General Mike Cox.

There were concerns that DMC’s facilities would eventually fall behind that of other hospital systems, precipitating an exodus of top doctors as well as patients with good insurance benefits who, unlike charity care recipients, have options.

“The DMC was not a model that was sustainable,” said John Levy, a member of the old DMC board and current chairman of its successor, the VHS of Michigan Advisory Board. “We have always had world-class physicians. We have not always been able to provide them world-class facilities.”

DMC approached six potential partners before settling down with Vanguard, a for-profit operator that specializes in urban market hospitals. Vanguard bought DMC for a $368-million purchase price and assumed a pension fund shortfall and other liabilities that came to an additional $293 million, according to the firm’s corporate filings.

The deal included a Renaissance Zone permit that gives 12 years of tax breaks for Vanguard-DMC and three more years at reduced rates. The permit saves the health system an estimated $14 million annually, although the company is estimated to still owe $6 million a year in new taxes for properties outside the zone.

To close the deal, DMC paid $30 million to the federal government in late December 2010 to settle self-disclosed allegations that the hospital system engaged in improper relationships with referring physicians, in some cases offering kickbacks in the form of cheap rent, sporting event tickets and charitable dinners. The alleged behavior stretched back to 2004, following Duggan’s arrival as CEO.

Duggan said in an interview this month that DMC chose to settle because it was up against a deadline to close the Vanguard deal, and the government’s process for fighting the allegations would have dragged out for months.

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“Everything was self-disclosed and there was no determination of wrongdoing,” Duggan said. “I believe that a federal determination would have found the great majority of the things we raised would have been determined not a violation.”

DMC’s financial challenges are punctuated by its Detroit-centric location. The health system has dozens of clinics and outpatient centers throughout the suburbs, though all but two of its eight main hospitals are in the city.

As a result, DMC hospitals treat many patients from lower-income households who lack adequate health insurance. These patients are often very sick by the time they arrive in a DMC emergency room and then require costly treatment.

DMC reports nearly 70% of its patients are Medicaid (36%) or Medicare (33%) beneficiaries. The industry average is typically 40% to 45%, said CEO Mullany. Hospitals generally make less money off Medicaid and Medicare patients than those with comprehensive private insurance.

“Detroit itself is one of the most concentrated areas of uninsured population and with a lack of primary care [physician office] than almost anywhere in the country,” said CEO Mullany.

Still, Mullany says it’s too soon to tell whether the complex Affordable Care Act will be a net-positive for DMC’s finances.as there are many facets to the new national health care law.

For instance, the law financially penalizes hospitals with high re-admission rates to contain costs by encouraging hospitals to give adequate treatment during a patient’s initial stay. This policy would in theory result in fewer in-patient stay -- meaning less hospital revenue.

Debt-financed deals

Started in 1997, Vanguard is a publicly-traded company majority owned by private-equity firms Blackstone and Metalmark Capital, formerly Morgan Stanley Capital Partners. Vanguard began from scratch and purchased all of its hospitals.

Bond analyst Vicki Bryan, who has followed Vanguard since the 1990s, said the company’s business model is risky because it involves buying struggling urban hospital systems in debt-financed deals.

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These types of hospitals, often money-losing, can be tough to quickly turn around, so Vanguard makes additional hospital acquisitions that improve the look of its balance sheet but not the firm’s core financials, according to Bryan, a senior high-yield bond analyst at Gimme Credit, an independent debt ratings firm in New York.

“Buying revenue (purchasing more hospitals) is not necessarily improving the operation, especially the kind of assets they can afford to buy,” Bryan contends.

Analyzing Vanguard’s bonds, J.P. Morgan reports the company’s standard debt-to-earnings leverage as 4.6x — meaning it would theoretically take Vanguard a little more than 4½ years to pay off all its debt. That figure generally aligns with its industry peers.

But Bryan points out that Vanguard keeps some debt commitments off its balance sheet, particularly the $850-million promise to DMC. For Bryan, a truer calculation of Vanguard’s leverage — excluding one-off revenue sources — is a nearly industry-topping 6.4x.

Vanguard did not dispute the analyst’s math, but a company representative said it wouldn’t be appropriate to have the DMC spending commitments on the firm’s balance sheet without also counting anticipated new revenue from the projects.

Said Pitts, Vanguard’s CEO: “We feel very comfortable with our current balance sheets and our current capability to meet our commitments.”